Top 5 Principles of Economics for Entrepreneurs

Economists love theory—and sometimes, they love theory so much that they forget about the applications. As an entrepreneur and an expert in practicality, you can enjoy the fruits of economic theories. Below: five principles of economics for people of action.

People respond to incentives.

When you fully understand this principle, the rest of economic theory seems redundant. The casual reader of popular economics (such as the ubiquitous Freakonomics by Levitt & Dubner or The Armchair Economist by Steven E. Landberg) knows that “People respond to incentives [and] the rest is commentary” (Landberg).

New parents learn this principle painfully when they try to pacify their toddlers’ tantrums with cookies and discover that their children throw even more tantrums. Self-interest, as Charles Wheelan puts it, “makes the world go round.” People respond even better to specific incentives—time-sensitive projects with time-specific rewards work better than vague promises.

As an entrepreneur, don’t let yourself forget this. Sure, people sometimes help you out of the goodness of their hearts (or because of their unsaid future expectations). But when you depend on people to give of their time, energy and money without reward, you put yourself at risk for shoddy work, misleading help, ignored deadlines, etc.

Make it a point to offer something in exchange whenever you ask for anything, and give back whenever someone does something for you. This principle applies to non-monetary situations as well: let’s say you want to have lunch with a business leader in your field. Find someone in your circle of contacts whom you might be able to connect with the person, and make your meeting about mutual gain instead of charity.

Thinking in terms of incentives will give you realistic expectations for others’ behavior. But there is a more important aspect of this rule—an aspect so important that it stands as a principle on its own.

Not all incentives are tangible.

In a simple economic model, the quantity of a product demanded by buyers decreases when its price rises, and increases when its price falls. Low prices incentivize people to buy more. Great! The lower your price, the more you’ll sell until you run into a shortage. But some goods defy the law of demand—people do things for non-monetary and non-physical reasons.

Examples abound, but we overlook them often. For instance, the heavy ‘sin tax’ on tobacco aims to de-incentivize tobacco consumption, but multiple studies show that people purchase almost the same amount of tobacco regardless of its price. (See Michael Palinkas, Are Cigarette Excise Taxes Effective in Reducing the Habit? and Frank Chaloupka, How Effective are Taxes in Reducing Tobacco Consumption?)

Sometimes, people even buy more of a product when it costs more money. Affectionately called ‘goods with snob value status,’ we call these products Veblen goods in the literature. A 50% discount on Tiffany’s jewelry or Rolex watches would actually decrease the number of buyers: people purchase these products in order to obtain social status.

Brand loyalty can also incentivize people to buy a more expensive product rather than a less expensive competitor. Advertisement-affected logic tells us “Cheerios must be better than the ShopRite brand ‘Cheery bits;’ I’ve eaten Cheerios my whole life.”

In all these cases, people make choices based on non-monetary incentives. You can and should take advantage of this knowledge—establish intangible incentives and keep clients coming back for something they can’t get elsewhere.

People face tradeoffs (opportunity cost).

As an entrepreneur, you’ll hear it again and again: “Outsource what you can.” This common-sense idiom comes from the economic principle of opportunity cost. Every time you choose to spend your resources (time, money) to gain one thing, you must subtract the things that you didn’t spend your resources on from your profit.

If you have $15 to spend either on a book or a lamp and you choose the lamp, you trade the opportunity to buy the book for the opportunity to buy the lamp. The book represents your opportunity cost. The same concept applies to time management.

If you choose to use your time toward one task, you incur the opportunity cost of another task: the more time you spend on a task that your associate can do better, the less time you can devote to projects at which you excel. Minimize your opportunity cost by placing value on your time: do the things you’re good at and outsource the things you aren’t.

Specialization helps.

Theorists have championed the benefits of specialization since 400 B.C. In The Republic, Plato outlines a society in which people divide the production of goods and distribution of services for a more stable society. Today, most people see prominent flaws in Plato’s system, but the division of labor and product specialization remain central devices for economic growth.

Imagine a simple economy in which two producers (Anne and Brett) manufacture two products (hats and shoes). If both Anne and Brett try to produce both hats and shoes, they will waste resources. However, if Anne produces hats and Brett produces shoes, they can trade and benefit from each other’s specialized work.

Likewise, we’ve known since the First Industrial Revolution that small-scale division of labor within a company accelerates growth: don’t try to do everything as a company, and don’t try to do everything as an individual. And the more specialized your product or service, the better the psychological effect on potential buyers as well.

Google, the classic example, succeeded as a search engine in part because of its specialized design—early on, Google didn’t market itself as a social network, map service, source of news and search engine. It started as a search engine that didn’t claim to do anything else.

People intuit that a company that only advertises one service must deliver the service better than a company that claims a variety of services.

Take rational risks.

Over coffee, economists and statisticians trade stories about peoples’ inability to discern probability. One such statistician (and philosopher), Nassim Taleb, wrote several books about the power of randomness (and counterintuitive statistics) to make people into “suckers.” “Suckers” impose their small-scale conceptions of reality on life (a huge set of potential events with many variables). More importantly, they take irrational risks.

People misunderstand improbable and random events in two [major] ways. First, they forget that these events are possible. In Fooled by Randomness, Taleb describes the game of Russian Roulette—in five out of six cases, you win $10 million. In one case, you die. Life, Taleb suggests, resembles a game of Russian Roulette in which you have thousands of chances to win and one to lose everything.

In this wider-scale case, people forget about the bullet. If you drive without a seatbelt for 5 years and don’t die, you haven’t eliminated the statistical chance of dying. On any given day, the chance of dying is a fraction of a percent, but if you take those risks every day, the improbable result will eventually happen.

Second, people overestimate the role of specific random scenarios, especially those on which the media choose to focus. I’ll highlight two well-known instances of this logical error.

Statistically, you’re more likely to die in a car accident on the way to purchase a lottery ticket than you are to win the lottery. Yet, state governments profit immensely off of lottery ticket sales. (See Andrew Carter for Newsweek/DailyBeast on March 30, 2012 “15 Things More Likely to Happen Than Winning Mega Millions).

Another example: the practice of hitchhiking ended in the U.S. almost entirely because of one case of kidnapping. The media exploded with the horror story of a hitchhiking woman held captive for years by a seemingly benign couple. After that, hitchhikers put down their thumbs, bought cars and preferred the (higher) risk of the driver’s death in a car crash to the risk of kidnapping. (See the transcript of the October 10, 2011 Freakonomics Radio Podcast, “Where Have All the Hitchhikers Gone?”). People respond to sensational stories about rare diseases, kidnappings, and shark attacks without considering the minute statistical likelihood of those events.

‘Don’t let randomness fool you,’ advises the economist. Take your time when you take a risk, and evaluate it rationally. At the same time, don’t let your feelings of fear cloud your judgment – some risks are well worth it.

Ellen Fishbein studies Economics in Manhattan, and works as an event planner and editor. She enjoys organizing small-scale group initiatives, singing opera and writing about the practical applications of economic and philosophical ideas.

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